Investors have responded to the extreme conditions of the last few years by moving money in and out of emerging markets, driven alternately by greed and fear.
Faced with potentially destabilizing bubbles as investors used cheap dollars to make short-term investments, the authorities in countries such as Brazil, Colombia, Philippines and more recently Uruguay have imposed some form of controls to limit inflows of ‘hot money’ – speculative funds looking for the best return possible.
At the same time, measures to limit outflows of foreign money are on the agenda in Europe as authorities grapple with the prospect of Greece and possibly other countries leaving the euro.
Earlier this year, Erik Berglöf, chief economist at the European Bank for Reconstruction and Development, said developing European Union countries might need to resort to capital controls if Greece leaves the single currency.
The attitude towards imposing capital controls, both among policymakers but also on the part of international financial institutions, is slowly becoming more permissive.
“It used to be that capital controls were automatically anathema to the IMF,” Amando Tetangco, governor of the Philippines central bank, tells Emerging Markets. “Recently there has been some openness to the imposition of capital controls provided that they are well targeted, they are time-limited and they are resorted to as a last resort.”
The Philippines has had to deal with inflows of capital over the past year as investors are looking for higher yield and, although it has stopped short of imposing traditional controls, it has had to introduce some measures to limit the flow of hot money.
“The IMF has changed to a certain extent in terms of its view,” Tetangco adds.
Go back just over a decade before the current crisis and the picture couldn’t have been more different. In 1997 and 1998, Malaysia imposed dramatic controls on investors in a bid to halt speculation against the ringgit during the Asian financial crisis.
The then-prime minister, Mahathir Mohamad, labelled George Soros a “moron”, and the legendary investor responded that Mahathir was a “menace to his own country”. Notwithstanding Malaysia’s strong recovery from the crisis, its actions reinforced the stigma that had become attached to capital controls, which had fallen out of favour as sentiment turned against the post-war Bretton Woods settlement.
However, the financial crisis has led to a reassessment of the role of capital controls.
In early 2010 the IMF surprised markets with a report that accepted capital controls as a “legitimate” means for countries to temper surging portfolio investments. The IMF has since issued further thinking on the subject and is expected to come up with a set of guidelines at its meeting this month.
“We see a role for capital controls, but it is a quite well-defined, very narrow role. We do think capital controls are useful in the right circumstances, but we don’t think they’re a substitute for taking more fundamental measures that may be needed,” Tamim Bayoumi, deputy director in the IMF’s Strategy, Policy and Review Department to Emerging Markets tells Emerging Markets.
The IMF’s partial conversion followed a period of turbulence for emerging market economies that was not of their own making.
After the collapse of Lehman Brothers in October 2008, investors pulled out funds from emerging markets that had surged earlier in the decade. But when developed nations slashed interest rates to bolster their economies, flows returned to emerging markets in search of better returns.
This carry trade forced up currencies in countries such as Brazil, which responded by imposing a tax on foreign purchases of Brazilian securities and later imposing reserve requirements and taxes on firms shorting the currency.
Hot money also sought returns in Asia. In the Philippines in the second half of 2010 and in 2011 the central bank noticed a significant rise in the volume of non-deliverable forward transactions (NDFs) – derivative instruments that allow foreigners to participate in the peso market, created mainly to help companies to hedge their currency exposure.
The increase complicated monetary policy as it added to the inflows of capital and increased the risk of banks with exposure to the NDFs, and the risk of the banking system as a whole, Tetangco explains.
“So we said, OK, we’re not going to close the NDF window, but since there are risks associated with this instrument, you have to set aside more capital. We increased the capital charge for NDF positions by banks. This has led to a reduction in the volume of NDFs.”
Offshore funds were also taking advantage of the positive interest rate difference between the Philippines and western economies by depositing money in the central bank’s special deposit account facility, which was created to give banks a place to park their excess liquidity.
“So we said the placements in the SDA facility coming from offshore funds would not be allowed. These are not foreign exchange controls; we used macro-prudential measures to address the problems that we encountered,” Tetangco says.
Pablo Goldberg, global head of emerging markets research at HSBC, says: “Policymakers in emerging markets have been trying to put a wedge between domestic monetary conditions and external monetary conditions. Quantitative tightening is the other side of quantitative easing. If you are doing quantitative easing you can’t protest too much if someone else is doing quantitative tightening.”
Olivier Jeanne, professor of economics at Johns Hopkins University, says the debate on capital controls opened up because this time the crisis started in the West.
“It became more acceptable to talk about controls in a market economy, but not because we had more capital flow volume or new
volumes after 2008. The global financial crisis for emerging market economies wasn’t very different from other booms and busts; the crisis hit the centre and made it more acceptable to put forward the idea that it was not good to have more and more financial liberalization.”
Capital controls’ proponents stress that the measures taken by emerging markets in recent years have been the opposite of those that gave controls their stigma.
CAPITAL ACCOUNT REGULATION
“When people think of capital controls they think of Malaysia in 1998 seizing existing assets so they can’t get out, but the new consensus is about trying to be more innovative to prevent the bubbles that can arise through inflows of capital,” says Kevin Gallagher, head of Boston University’s Pardee Task Force on Regulating Global Capital Flows for Development.
Capital controls are being rebranded to fit their new more respectable status.
Gallagher refers to them as “capital account regulation” while the IMF uses “capital flow management measures” for its preferred actions. Gallagher says the change of language reflects the new purpose of capital controls in a world where the consensus is now that finance went unchecked for too long.
Financial regulations underwent a whole rethink, he says, with everything regulated apart from the cross-border component of capital flows, which is referred to as ‘controls’, and the recommendations are to deal with the short-term capital flows not with the direct investment, he adds.
“What you are trying to do with capital account regulation is to increase the maturity of the inflows,” Gallagher says.
Away from the booming markets of Asia and Latin America, the turmoil has raised the prospect of using capital controls to deal with fiscal crises in Europe. When the IMF intervened in Iceland’s financial collapse in 2009, it directed the country to impose capital controls and even sent in experts to help the embattled island nation draw them up.
Research consultancy Capital Economics has argued that controls would be needed if Greece left the euro in a measure that would be closer to the old idea of capital controls – that of preventing a flight of assets – than efforts to deter hot money.
PARTIAL CHANGE
However, the IMF’s conversion is only partial, and for some its stance remains a missed opportunity. The IMF accepted capital controls as a measure to be used in the short term after more conventional actions such as allowing the currency to appreciate, accumulating more reserves and altering fiscal and monetary policy.
Gallagher says: “There are IMF staffers who don’t think these regulations should exist, and that is reflected in the IMF’s more timid approach.”
The IMF remains fearful of the unintended consequences
of capital controls, including knock-on effects to other countries as investors seek out alternatives when controls are erected. Jonathan Ostry, who leads the IMF’s work on capital controls, has warned that such measures can distort investment flows and lead to a ‘beggar-thy-neighbour’ situation, in which countries trying to fend off the effects of capital inflows or outflows hurt other economies in the region, forcing them to take defensive measures in their turn.
There is also the question of whether controls are effective in overcoming the ingenuity of portfolio investors while encouraging long-term investment.
Neil Shearing, Capital Economics’ chief emerging markets economist, doubts that this is the case. “If you look at Brazil, it did seem to lead to a short-term tapering off of more speculative flows, but there has been lots of speculation as to whether flows have been rebadged as foreign direct investment going through various subsidiaries.”
Gerard Lyons, chief economist at Standard Chartered, says: “The reality is it is difficult to find controls that differentiate easily between hot money and longer-term flows, and countries that have adopted capital controls have in the past been penalized by international investors.”
Jeanne says the IMF’s shift of position is welcome but that its restraint in embracing capital controls means the fund is missing the chance to come up with rules on the measures countries can adopt.
“Brazil is reluctant to give the IMF more power to oversee capital controls because the IMF’s enthusiasm is not very strong and it is reversible. The next managing director could decide not to endorse controls,” he says.
“What we are saying is that the international community, for example the IMF, could use increased acceptance of the right kind of capital controls to define by exclusion capital controls that are harmful and should be discouraged.”
He accepts that China, with its huge reserves and managed currency, would be unwilling to take part but argues that countries with relatively open capital accounts would be willing to do so. Such a change would take away the false distinction between the strictly regulated trade in goods and permissiveness on capital flows.
Goldberg at HSBC argues that the IMF’s change of tack simply acknowledged the world as it had become. His occasional research called “capital controls radar” totted up about 80 controls and macro-prudential measures adopted in emerging markets in the two and a half years to June 2010. He has not published an update since that time because the market has been quieter, but he argues the long-run trend is here to stay.
“The structural phenomenon is these are now considered viable alternatives in the context of the extraordinary reaction in developed markets. Controls are not seen as taboo any more and in some cases are seen as a natural response to new developments in the international arena.”
Even as the stigma attached to capital controls reduces, the inflows that trigger their use are likely to keep increasing as investors seek better returns in a low-interest world.
Increased financial flows from west to east are likely in the coming years, partly because growth prospects will be better and partly because institutional investors are under-invested in the developing world, according to Lyons.
“The future dilemma is that emerging economies generally don’t have the ability to absorb easily the likely future inflows,” he says.
“If it were possible to use a version of capital controls to deter hot money while leaving them open to more positive FDI flows, they would probably do so. It’s not a case of saying what countries should automatically do.
“We need to move towards more open markets, but I don’t think people can be oblivious to the challenges [facing emerging markets] especially when we have to search for yield and interest rates are so low.”
Policymakers in emerging markets are divided over the use of capital controls, but many still prefer that markets work relatively freely. In the Philippines, the central bank does not intervene in foreign exchange markets – unless it wants to prevent sudden moves in the exchange rate that would destabilize the economy.
“To us, what we have so far done and what we continue to believe is that we should allow market forces to work,” Tetangco says.
When it comes to capital controls, the facts have changed, and the IMF has slowly been changing its mind. It remains to be seen whether its moderate conversion will be able to keep pace with events.